RiskMinds 2010 - Day 2 - Paul Embrechts on Financial Engineering

I started the day with a presentation by Paul Embrechts (see previous RiskMinds post here) entitled "Financial Engineering And The Financial Crisis: Warnings, Guilt and Lessons Hopefully Learned".

Paul first pointed out that if ever there was a bubble, it was a "bubble" of books on the crisis and its causes. He listed a number of reasons for the crisis, most interesting/new of which was in addition to "too big to fail", was "too big to save" as a new risk given the size of some financial institutions relative to the economies they operate in. Paul has an extensive academic background in both financial risk management and actuarial studies, and I guess it was with his actuary hat on he said that the three main problems for financial engineers going forward were "social insurance, social insurance and social insurance".

By social insurance Paul was referring to medical, life and health insurance and saw this as his big concern for the future. He illustrated this through showing the age distribution of the Japanese population from 1950, 2007 and 2050. Basically the 1950 distribution was like a pyramid with a very young population underneath the middle and old-aged. This shape changed to being fatter in middle age for 2007, and is predicted to be inverted with more older people that younger in 2050. Given that this will result in a percentage reduction of more than 10% in working population supporting an increasingly older population it was not difficult to see what he was meaning.

Paul spent some time going through old papers from him and others (particularly Joseph Stiglitz on securitisation in 1992) warning of the 2008 crisis - I do not know his work well enough to know how much this was "wise after the fact" but what he mentioned on securitisation and correlation made sense given what has since happened. Worth taking a look on his website for some of his papers on Basel and risk management I guess.

One key point he made was simply about volume. Working admittedly on a notional basis, he said that having an OTC derivatives market with notional value of $583 trillion is interesting in the context of a world economy with GDP of only $58 trillion. Even netting notional down you get around $30 trillion of OTC derivatives which still deserves our attention and our efforts to make things better in risk management. I guess his simple message here was "pay attention to volume".

He said the use and abuse of the Repo 105 rule was worth looking at (so I will, anyone with knowledge please let me know), and also questioned the societal benefit of high frequency trading (HFT). Looking back at the Flash Crash Paul said that this was a new kind of risk for risk managers and he had no idea how to hedge it.

Paul defended mathematics as the solution to some of the problems of the crisis and not as the cause - fundamentally he thinks the press have given maths bad PR. He said that we should all watch out for the word "new" being used, as this indicates the start of a bubble with phrases such as the "new economy". Overall a great speaker very comfortable with his subject matter.